An extremist, not a fanatic

March 06, 2012

Tax the (middlingly) rich

The coalition’s confusion over its plan to remove child benefit from people in the 40% tax band raises an issue that all politicians would rather ignore: namely, the structure of marginal taxes.

The problem with withdrawing child benefit is that someone earning just under £42,745 faces a massive marginal tax rate because she would lose child benefit if she gets a pay rise.

Of course, marginal deduction rates of several hundred per cent are undesireable. The best way to demonstrate that we‘re “all in this together“ is not to remove child benefit from the rich, but to tax them more heavily.

And this is where economics and politics collide violently, because there is a sound economic case for having higher marginal tax rates on the middlingly rich - those in the current 40% tax band - than on the super-rich.

This is because the super-rich are more likely to reduce their taxable income in response to higher marginal rates than the middling sorts. And as Greg Mankiw wrote in his nice survey (pdf) of optimal tax theory:

If high-income workers are particularly elastic in how their taxable income decreases with higher tax rates, this would imply lower optimal marginal tax rates on high incomes

Empirical work (pdf) in the US by Gruber and Saez has demonstrated just this - that there’s a case for lower marginal taxes on very high incomes than on slightly lower ones.

There are (at least) four reasons why the super-rich are more likely to be on the “wrong” side of the Laffer curve than the middling sorts:

1. They are footloose. A hedge fund manager can move to Switzerland more easily than can a head teacher.

2. There are deadweight costs of dodging taxes. Paying fancy accountants and lawyers is not worth the effort for a middling earner aiming to save a few hundred quid, but it for someone aiming to save a few thousands.

3. The very rich can afford to retire if they think the government is ripping them off. Those of us on middling incomes cannot.

4. The super rich might have lower tax morale than others. The very fact that they are rich is evidence that they are more motivated by money than the rest of us, which suggests they might resent higher marginal taxes more. And this, combined with points 1 -3, might lead them to cut their taxable income in response to high marginal taxes. It more efficient to tax the compliant than the non-compliant.

These points all argue for lower marginal taxes on the very rich than the middlingly so - though whether this points to a 40%-10% structure or a 60%-50% is a separate issue.

Such a structure is, however, politically infeasible. But it needn’t be.

This is because low marginal taxes on the rich are quite consistent with progressive average taxes. Imagine an income tax system in which the first £10k is tax-free, the next £30k is taxed at 20%, the next £110k at 60% and incomes above £150k are taxed at 30%. Then someone on £25k faces an average tax rate of 12%. This is only one-fourth the average rate paid on £150k, and one-third that paid on £200k. Over most incomes - 99% - the tax system is progressive. Yes, average tax rates fall as incomes rise beyond £150k. The guy at the bottom of the top percentile might complain. But so what?

What’s more, income tax is not the only redistributive tool. I’d like to see it accompanied by: land value tax; worker democracy to rein in bosses’ rent-seeking; and a culture war against managerialist ideology.

Lower marginal rates on the rich, then, might be consistent with more egalitarianism than we presently have.

Comments

Very interesting and pleasingly non-partisan. The problem with it is a political one. In the uk the main parties have all to some extent pushed the line about the squeezed middle. It is pretty obvious that the middle are always the easiest and most productive ones to squeeze but they also form the largest part of the electorate. It would take some bravery to attempt it when even small and poorly conceived squeezes like withdrawal of child benefit get howls of anguish and outrage from both ends of the spectrum.

I think it's honestly getting to the stage where we should consider using the military to take down tax havens.

When sovereign nations undermine the interest of the majority of the population of the world in such an upfront way it's only fair and reasonable to fight back.

I think that's probably also interestingly also the one argument in favour of retaining the nuclear deterrant - while an invasion of Caymen might not be cost-effective, a single warhead - or the threat of one - would probably do the job fairly well.

What about the fact super-rich people can use their wealth to skew legislation-making to their own particular interest? If this is a serious problem (and I'm not sure if it is, but it is not unlikely), you would encourage the super-rich people facing higher marginal tax rates to retire.

Academic research may show that this method is one way of reducing tax avoidance by the wealthy. However, this approach seems to simply accept that, and make everyone else pay, or rather a vast swathe of people in the middle who have little choice but to accept whatever tax rates a government imposes. This is grossly cynical and unjust.

This method is _not_ consistent with progressive average rates, as above the maximum at an income of £150k here (at 48%), the average rate starts to drop, such that our happy banker on £1m would face an average rate of 32.7% - the same as a manager on a shade under £66k.

Tinkering with marginal tax rates in an attempt to make the revenue raising system itself redistributive is a waste of effort. Do that with the revenue raised instead!

Incidentally, the suggestion that the UK should tell other countries to vote for higher taxes or be nuked is perhaps the most sickening comment I've ever read on a blog. Incredible.

I like this, but isn't it worth adding that we have this already? Currently, the personal allowance is withdrawn once income reaches £100k (see:http://www.hmrc.gov.uk/budget2011/rates-allowances.pdf) means that people are paying a higher marginal rate between £100k and £115k(ish) then they are above that amount.

That the super-rich should be spared because they are footloose or whatever is frankly ridicolous. You say past evidence proves that, but past evidence is based on past political mainstream. It is also nonsense to argue that civil servants wouldn't be able to track down the super rich were they given the necessary political backing to do so. It's only about political will Chris, there is no hiding/dodging if Western economies for example signed up to a mutually beneficial cartel agreement to raise taxes uniformly on the super rich and back each other up. Look at what is happening in Italy right now for example, as soon as Monti's govt gave the go-ahead to the department responsible for tax collection a flurry of activity (surprise inspections and so on) has scared the hell out of everyone there, and this is just the beginning....
This idea that expensive private lawyers & accountants can systematically out-smart civil servants is not only defeatist but frankly strongly ideological.

How many of these people on over £150k are really genuinely wealth creators?
If we took a different approach to your proposal here and simply had these people shot and their assets confiscated and redistributed, how much productive potential would the economy really lose? Not as much as these people would have you believe, I'd wager.

I think some commenters have missed the irony that we already have a system that allows the wealthy to pay a lower average rate of tax than the middling sort, through a variety of dodges such as income disguised as capital gains or corporate profit. Chris's suggestion of a lower top rate of income tax just makes this unpalatable truth visible.

As regards the nuclear option, I think the collateral damage should we flatten the City of London, not to mention the Channel Islands and the Isle of Man, might be too great to consider, particularly in an Olympic year.

More seriously, the key focus should be taxes on land and other forms of non-portable wealth. These are less vulnerable to "tax optimsiation".

An alternative study would be on the effectiveness of income as an incentive. I suggest a Laffer curve for Incentive verses Income. Once you achieve a comfortable income, further increases are no longer an incentive.

How much control does an individual have on how much work they do anyway? Employees have little or no control, limited to the availability of overtime. And even then, the private and public sectors rely very heavily on unpaid extra hours. Which makes working-to-rule an effective form of industrial action. Even on commission schemes, opportunities are limited in practice.

Speaking as a lowly cog in the machine, I've never met anyone whose work-rate was affected by the tax-rate. Affected by many other factors, yes. Tax-rates simply do not work as incentives to work.

Isn't another argument that there simply are not enough rich people, even if you could make them all pay tax at 80%, to cover the additional costs of demographics, climate change etc which will hit the state during the next decade.

The larger group in the middle will end up having to pay more tax too.

@ChrisO
I've worked alongside very many IT contractors & other self-employed for the best part of thirty years. I've discussed with them their tax arrangements, their motivations and the state of the contracting market, etc, and never once did they claim that the tax rate made one iota of difference to them. I suggest you try it.

Apply some elementary logic. If the tax rate affects the amount of hours worked, people would work longer hours under a higher tax rate to compensate for the shortfall. A higher tax rate doesn't make peoples' mortgages and families magically disappear. A higher tax rate would be a greater incentive to work.